DRI Today - Legal Research, Law Blog and Magazine Archives - Elizabeth-H-Getches-and-Scott-R-BauerDRI’s flagship publication for over 40 years, is a national, monthly publication that contains original writings on topics of professional interest to lawyers and others concerned with the defense of civil actions.http://dritoday.org/
http://www.rssboard.org/rss-specificationBlogEngine.NET 1.6.1.0en-GBhttp://dritoday.org/opml.axdhttp://www.dritoday.org/syndication.axdDRIDRI Today - Legal Research, Law Blog and Magazine Archives0.0000000.000000Fiduciary Duties in the Zone of Insolvency<p>During these challenging economic times, as companies face cash-flow problems or even decide to cease operations, creditors will likely attempt to push the envelope with respect to claims against directors of insolvent corporations and managers of insolvent limited liability companies. It is commonly understood that once an entity is insolvent, a director&rsquo;s fiduciary duties shift from the corporation&rsquo;s shareholders to its creditors. Whether, and to whom, duties are owed immediately prior to a company&rsquo;s insolvency, in the so-called &ldquo;zone of insolvency,&rdquo; involves important considerations for corporate counsel and anyone serving as a director.<br />&nbsp;<br />The origin of the &ldquo;zone of insolvency&rdquo; issue can be traced to the decision in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. Dec. 30, 1991). The Delaware Chancery court held that directors should be afforded the traditional protection of the business judgment rule even when a risky strategy might ultimately prove harmful to creditors. Footnote 55 of the Credit Lyonnais opinion caused some courts and commentators to opine that new and expanded fiduciary duties were created when a company is in the zone of insolvency that may be enforced by creditors through direct claims. Id. at *34, n. 5 (&ldquo;[t]he possibility of insolvency can do curious things to incentives, exposing creditors to risks of opportunistic behavior and creating complexities for directors&rdquo;). See, e.g., Weaver v. Kellogg, 216 B.R. 563, 582-84 (S.D. Tex. 1997); Official Comm. Of Unsecured Creditors of Buckhead America Corp. v. Reliance Capital Group, Inc. (In re Buckhead Am. Corp.), 178 B.R. 956, 968 (D. Del. 1994); Royce de R. Barondes, Fiduciary Duties of Officers and Directors of Distressed Corporations, 7 GEO. MASON L. REV. 45, 65-70 (1998)(&ldquo;the duties owed by directors of solvent, distressed corporations can be affirmatively enforced by creditors&rdquo;).</p><p>This interpretation of Credit Lyonnais was put to rest in the decision in Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772 (Del. Ch. 2004). The Production Resources court held that, with limited exceptions (such as where directors demonstrate a &ldquo;marked degree of animus&rdquo; toward a particular creditor), creditors&rsquo; claims for breach of fiduciary duty claims are derivative claims, not direct claims. Id. at 791-93. </p><p>The court also held that exculpation clauses under Section 102(b)(7) of the Delaware Corporate Code apply to &ldquo;all claims belonging to the corporation itself, regardless of whether those claims are asserted by stockholders or by creditors.&rdquo; Prod. Resources, 863 A.2d at 793. The reasoning behind the decision was that fiduciary duty claims brought by creditors should &ldquo;at most be coextensive with, and certainly not superior to,&rdquo; the claims that a solvent firm itself could bring against its directors. Id. at 794. Indeed, &ldquo;[i]t would be puzzling if, in insolvency, the equitable law of corporations expands the rights of firms to recover against their directors so to better protect creditors, who unlike shareholders, typically have the opportunity to bargain and contract for additional protections to secure their positions.&rdquo; Id. </p><p>Finally, the court held that directors defending against breach of fiduciary duty claims are entitled to the protection of the business judgment rule. Id. at 788-89. The court even noted that circumstances may exist where directors, in the exercise of their judgment, appropriately prefer one or more creditors over others of equal priority, as long as that decision is not motivated by self-interest. Id. at 797. </p><p>In light of the Production Resources decision and its progeny, the following considerations should be undertaken by counsel defending against a breach of fiduciary duty claim:</p><p>(1) <strong>Motions to Dismiss</strong>. Any attempt by a single creditor to bring a direct claim on its own behalf, as opposed to one that would benefit all creditors, should be the subject of a motion to dismiss. The Tenth Circuit echoed the court in Production Resources by holding that a single creditor can only bring a claim on behalf of the corporation, not as a direct claim. Delgado Oil Inc. v. Torres, 785 F.2d 857 (10th Cir. 1986)(citing Ficor, Inc. v. McHugh, 639 P.2d 385 (Colo. 1982)). The Colorado legislature amended the corporate code to clarify that creditors have no claim against directors and officers prior to a corporation&rsquo;s insolvency. C.R.S. &sect; 7-108-401(&ldquo;A director or officer of a corporation, in the performance of duties in that capacity, shall not have any fiduciary duty to any creditor of the corporation arising only from the status as a creditor.&rdquo;). In applying this statute, the Colorado Supreme Court held that &ldquo;officers and directors of an insolvent corporation owe creditors a duty to avoid favoring their own interests over creditor claims.&rdquo; Alexander v. Anstine, 152 P.2d 497, 498 (Colo. 2007).</p><p>(2) <strong>Exculpation Clauses</strong>. Carefully drafted exculpation clauses in articles of incorporation and other entity formation documents will limit or perhaps even eliminate director&rsquo;s liability for claims which creditors bring derivatively. Section 102(b)(7) of the Delaware Corporate Code authorizes corporate charter provisions that insulate directors from personal liability to the corporation or to its shareholders for breaches of the duty of due care, but not for breaches of the duty of loyalty. 8 Del. C. &sect; 102(b)(7). The Colorado corporate code similarly protects a director from personal liability to the corporation for breaches of the duty of care. C.R.S. &sect; 7-108-401. Whether these protections apply to managers of limited liability companies is an open question.</p><p>(3) <strong>Business Judgment Rule</strong>. Counsel representing distressed companies should consider ways of maximizing the utility of the business judgment rule. Because the business judgment rule applies to decisions made by the board of directors, as opposed to corporate officers or other representatives, all significant decisions &ndash; to the extent possible &ndash; should be made, or ratified, by the board. Thus, it is imperative that these decisions are both (a) adequately informed and (b) appropriately documented by board books and minutes.</p><p>(4) <strong>Defining Insolvency</strong>. A plaintiff&rsquo;s expert will likely attempt to retroactively adjust a company&rsquo;s valuation of goodwill, often considered a significant asset for a going concern. An awareness of the different tests which have developed for defining insolvency may prove imperative in limiting damages. Balance sheet insolvency defines insolvency as the moment when the entity has &ldquo;liabilities in excess of a reasonable market value of assets held.&rdquo; Blackmore Partners, L.P. v. Link Energy LLC, 2005 WL 2709639, *6 (Del. Ch. Oct. 14, 2005). The cash flow test projects into the future to determine whether capital will remain adequate over time instead of focusing on whether the corporation has been paying bills on a timely basis. Geyer v. Ingersoll Publications, Co., 621 A.2d 784, 799 (Del. Ch. 1992). </p><p>Elizabeth H. Getches<br />Scott R. Bauer (<a href="mailto:scott.bauer@moyewhite.com">scott.bauer@moyewhite.com</a>)<br />Moye White LLP<br />Denver, Colorado</p>
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Elizabeth H. Getches and Scott R. Bauerhttp://dritoday.org/post/Fiduciary-Duties-in-the-Zone-of-Insolvency.aspx#commenthttp://dritoday.org/post.aspx?id=bdb847c2-1545-4036-935b-c3cd317c705fThu, 18 Dec 2008 08:03:00 -1200Commercial LitigationElizabeth H. Getches and Scott R. Bauerhttp://dritoday.org/pingback.axdhttp://dritoday.org/post.aspx?id=bdb847c2-1545-4036-935b-c3cd317c705f8http://dritoday.org/trackback.axd?id=bdb847c2-1545-4036-935b-c3cd317c705fhttp://dritoday.org/post/Fiduciary-Duties-in-the-Zone-of-Insolvency.aspx#commenthttp://dritoday.org/syndication.axd?post=bdb847c2-1545-4036-935b-c3cd317c705f